Decentralized finance is Blockchain-based finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments and instead utilizes smart contracts on blockchains, the most common being Ethereum.
DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.
There is no agreed-upon date about when decentralized finance was introduced. There are few important events that made Defi successful. The first of them was the introduction of bitcoin in 2009 by Satoshi Nakomoto. Despite the case of whether bitcoin should be classified as DeFi or not, its inception was the key enabler for the whole cryptocurrency industry, which decentralized finance is part of. Bitcoin also allows sending payments around the world in a decentralized fashion. But more importantly, bitcoin enabled the creation of Ethereum, a default blockchain for all the top DeFi protocols.
Although sending bitcoins around the world is cool, finance does not stop there; every robust financial system requires a set of other services like lending, borrowing, trading, funding or derivatives. Bitcoin, with a limited language called script, was just not suitable for these kinds of applications. Scripts limitations were one of the most important factors that contributed to the creation of Ethereum by Vitalik Buterin.
Ethereum was launched in 2015 and quickly started attracting more and more developers who wanted to build all kinds of decentralized applications ranging from games such as Crypto Kitties to financial applications. Ethereum, with its true incomplete programming language, Solidity, and the ERC 20 standard for creating new tokens, quickly became a go-to smart platform to build on. This leads the ecosystem to one of the oldest DeFi projects on Ethereum called Maker.
Maker is a protocol that allows creating a decentralized stable coin. Dai. The project was formed in 2014 by Roon Christensen. He was inspired by another project, Beachers, a blockchain created by Dan Larimer. The development of Maker was funded by Venture capital and was eventually launched at the end of 2017. In the first iteration of the protocol, single collateral Dai supported only Eth as collateral. This was later expanded to multi- collateral Dai, which was launched in 2019. Maker remains one of the important projects in DeFi and is clearly one of the early pioneers of the whole Decentralised Finance space.
Another project worth mentioning was Ether Delta. Ether Delta was one of the first Decentralized Exchanges built on Ethereum that allowed for a Permissionless exchange of ERC 20 tokens. The exchange was based on an order book. As we know, building order book exchanges on layer 1 are hard and usually results in a poor user experience. Despite Ether, Delta was one of the most popular exchanges for trading different ERC 20 tokens, especially during the ICO era. The exchange was hacked in 2017. The hacker gained access to the Ether delta frontend and proxied the traffic to a fishing site scamming the users for around 800,000 dollars. On top of this, the founder of Ether Delta was charged by the SEC for running an unregulated security exchange in 2018, which was pretty much a nail in the coffin.
Also, during 2017, the first big use cases of Ethereum ICOs became prevalent. New products, instead of raising money using traditional methods, started offering their own tokens in exchange for Eth. However, the idea of Decentralised Fundraising was not bad in theory. It resulted in multiple projects raising way too much money without anything to show besides a few pages of white pepper.
In the plethora of ICOs, there were a lot of projects that we would today classify as DeFi. Some of the most notable DeFi products from the ICO era were AAVE, Lending and Borrowing; Synthetix, previously known as a haven, a liquidity protocol for derivatives; Ren previously Republic protocol, a protocol for providing access to inter blockchain liquidity; Kyber network, an on-chain liquidity protocol; 0x, an open protocol, that enables peer to peer transaction of assets; banker, another on-chain liquidity protocol.
It is interesting to see that despite the bad reputation of the 2017 ICO mania, the projects that emerged back then are now considered as the top protocols in DeFi. One of the main breakthroughs was the idea of users interacting with Smart Contracts containing pulled funds from multiple users rather than interacting directly with other users. This basically created a new User to the Contract model that was more suitable for Decentralised Applications as it didn’t require as many interactions with the underlying blockchain as the User to the User model.
After the ICO mania, the bear market kicked, DeFi experienced a relatively quiet period. In reality, major DeFi protocols were being built.
We usually call this period of time, Before Comp. Compound’s Comp token liquidity mining created an evolution in DeFi. There were also a few other important protocols and events that happened during the seemingly quiet period of time.
On the 2nd of Nov 2018, the initial version of UniSwap was published to the Ethereum MainNet. This was a combination of over a year’s worth of work by its creator Hayden Adams. Uni Swap is clearly one of the most important projects in the DeFi space. In contrast to Ether Delta, UniSwap was built on the concept of liquidity pools and Automated Market makers, leveraging the previously discussed User to Contract model.
The first version of UniSwap was entirely funded by a grant from the Ethereum Foundation. In July 2019, another important event happened. Synthetix launched the first liquidity incentive program, a mechanism that later became a key catalyst for the DeFi summer of 2020. Also, multiple other DeFi projects launched the protocols on the Ethereum MainNet between 2018 and 2019. This included compound, Ren, Kyber, and 0x. On the 12th of March 2020, the price of Eth shrunk by more than 30% in less than 24 hours. This was one of the biggest tests for the still-nascent DeFi industry. The Ethereum gas fees spiked over 200 GWEI, which was really higher at that time as a result of multiple users trying to increase their collateral in various loans and trying to trade between different assets.
One of the most affected protocols in this event was Maker. The wave of liquidations caused by users of Eth collateral losing value resulted in the keeper bots. External players were responsible for liquidation, being able to bid zero Dai for the auction Eth collateral. This led to a shortfall of around 4 million dollars worth of Eth, which was later accommodated by creating and auctioning additional Makers, MKR Tokens.
This brings us to the major DeFi growth, also called the Defi summer. The main catalyst of Defi summer was the liquidity mining program of Comp tokens launched by Compound in May 2020. Defi users are rewarded for lending and borrowing on the Compound. The extra incentives as Comp tokens. This facilitated the development of Yield Farming as users were incentivized to keep switching between borrowing and lending different tokens to achieve the best yield possible. This event also initiated the wave of other protocols distributing their tokens via liquidity mining by creating more and more yield farming opportunities. It also created Compound governance to vote on different proposed changes to the protocol. The Compound governance model was later reused by multiple other DeFi projects.
This brings us to another DeFi protocol, Yearn Finance. Yearn was developed by Andre Cronje in early 2020 as a Yield Optimizer that focuses on maximizing DeFi capabilities but automatically switching between different leading protocols. To further decentralize yearn, Andre decided to issue governance token Wifey to the yearn community in July 2020. The token was distributed via liquidity mining. This model attracted global support from the DeFi communities, with money flowing into the incentivized liquidity pool clocking 600 million dollars in locked value. The token price itself started its run from around 6 dollars when it was first listed on Uniswap to over 30,000 $ per token in 2 months. Yearn’s success was quickly followed by multiple competitors by launching similar projects with a few alterations.
Another project that started gaining more traction due to its unique elastic supply model was Ample Forth. This model was very quickly reiterated by another DeFi protocol Yam.
Yam development was launched on the 11th of August 2020. Yam tokens were distributed within the spirit of Wifey, and the protocol attracted a lot of liquidity. The protocol built interest in strong DeFi communities by rewarding holders of Comp, Lend, Link, Maker, SNX and Wifey for staking their tokens on the yam platform. Just one day after the launch, with half-billion dollars of total value locked in the protocol, a bug had been identified rebase mechanism. The bug affected only a portion of liquidity providers in the pool. YCRV-Yam. But this made people lose interest in Yam despite their later attempts to relaunch the protocol.
Then comes Sushi Swap, launched at the end of august 2020 by an anonymous team. The protocol introduced a new concept of vampire attack that aimed at siphoning liquidity out of UniSwap by incentivizing liquidity providers of uniswap with sushi tokens. Sushi Swap was able to attract as much as 1 billion dollars worth of liquidity. After some drama with the main Sushi Swap developer and Chef Nome selling his entire stake of sushi tokens, the protocol was eventually able to migrate a lot of uniswaps liquidity onto their new platform.
During the summer, there were a lot of other projects of varying quality being launched. Most of them were just iterations of existing open-source projects trying to benefit from the over-exuberance in a completely new industry. Following Yam and Sushi, there were a bunch of other projects named after different kinds of foods being launched.
One of the major events of DeFi summer was the launch of the Uni wap token, Uni. All the users and liquidity providers of UniSwap were rewarded with a retrospective airdrop worth well over 1000 dollars. On top of that, Uni Swap started its liquidity mining program across four different liquidity pools and attracted more than 2 billion $ in liquidity. Most of which was taken back from the Sushi Swap.
During the DeFi summer, all of the key DeFi metrics improved dramatically. UniSwap’s monthly volume went from 169 million in April 2020 to over 15 billion $ in Sep 2020. A massive increase of almost 100x. Total value locked in DeFi went from 800 million$ in April to 10 billion dollars in Sep and over 10x increase.
The amount of Bitcoin moved to Ethereum raised from 20,000$ in April to almost 60,000$ in Sep, a 3x increase. The market sentiment quickly changed at the beginning of Sep 2020. Major DeFi tokens started losing their value. The yield from liquidity mining that is derived from the values of distributed tokens also became lower and lower.
The DeFi winter has come. The negative sentiment lasted throughout Sep and Oct despite the DeFi ecosystem still being very active, with developers continuing to build new default protocols. The DeFi market finally reached its bottom in early Nov, with some of the top DeFi protocols trading 70-90% lower than its usual range just a couple of months earlier. After a quick rebound, the DeFi market started trending up again. Interestingly during the DeFi winter, the UniSwap volume still remained much higher than its early 2020s. Also, the DeFi kept trending upwards, topping 15 billion dollars at the end of the year.
At the end of 2020, with Bitcoin breaking its previous record in 2017, it looks like DeFi ready for another parabolic run. Looking further into 2021 and beyond, the future of DeFi is advanced. The DeFi developers keep building new innovative projects. The imperative scaling is also emerging in the form of Ethereum 2.0 layer two solutions and even other blockchains. This will attract the users to start participating in DeFi. It will also help to discover new use cases that were previously just not possible due to high network fees; bringing new, more traditional assets in DeFi by either tokenizing them and creating their synthetic versions will also open up new opportunities. The Competition between DeFi on layer 2, DeFi on Ethereum 2.0, DeFi on bitcoin, and DeFi on other blockchains will also play a big role. Interoperability protocols and cross-chain liquidity may unlock DeFi’s potential. Other areas such as credit delegation and under- collateralized or non-collateralized loans are also being explored. This will all become clear in the days to come.